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Will the Green Deal really work or go the same way as Labour's New Deal?

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Is Chris Huhne's 'Green Deal' just a marketing strategy?

Sam Arie

25th november,2011

The 2011 Energy Act provides for a ‘Green Deal’ in which households will be encouraged to borrow money on easy terms to finance energy saving home improvements. But will it work?

We have been living from bubble to bubble. First the dot com bubble, then the housing bubble, and you could hardly have missed the Southern European bond market bubble. It is as if we are in constant search of a new folly in which to lose our heads – and then our shirts. But if anyone has been wondering where the next bubble will come from, we have the answer: it will be an energy bubble.

We know this, because we now have legislation to make it so. The 2011 Energy Act provides for a ‘Green Deal’ in which households will be encouraged to borrow money on easy terms to finance energy saving home improvements. The consultation papers published by DECC this week suggest that £14 billion in new loans will be created from now to 2020, but the government has also said that the eventual goal is for 26 million homes to take part, with loans of perhaps £5,000 each. Following that logic, total lending would be closer to £140 billion than £14 billion. Either way, these are staggering amounts for a green scheme – and more than enough to get a decent bubble going.

Of course this kind of money must come from somewhere, and since it will be households who borrow the money, it will be households who have to pay it back again. From this point of view, it is not the size of the scheme that matters as much as the quality of the investments that are carried out, since that is what determines whether households can repay their loans.

Unfortunately there are two reasons to expect that Green Deal investments will be of poor quality. The first is that there simply is not a huge supply of attractive home energy saving investments to be made, because contrary to popular imagination energy remains extraordinarily cheap in the UK – gas prices may have doubled in the past decade, but they are still 30-40 per cent lower than in the rest of Europe. Indeed it is because UK energy prices (including taxes) are so low that a typical investment, like replacing a gas boiler, will typically not save enough energy to pay for itself within the lifetime of the product. You do not replace your boiler, as everyone knows, until it breaks down.

This is important, because the premise of the Green Deal is that loans will be financed by the energy savings they create. But since more often than not that is difficult to do, there will always be pressure for providers to exaggerate the savings, or the lifetime of the technology, or some other feature, in order to encourage householders to take out a loan. And while in normal cases a householder might be resistant to such pressures, in this case they will be open to persuasion – because of the second big problem with the design of the Green Deal.

The second problem with the design of the Green Deal is that it separates the person taking out the loan from the person who has to pay it back. If you take out a loan and then move house, the new owner will take over the repayments. But what this means in practice is that you will have less incentive to scrutinise the terms of the loan you’re taking out, in particular to understand if the energy savings being promised are really achievable.

At the same time, the other parties involved in setting up your Green Deal loan – the assessor, the installer, the energy company, the finance provider – will all have strong incentives to get the loan agreed, because that’s how they’ll earn their fees. In addition, the loans will be securitised and sold on in the secondary market, so not even the financing company will share the risk that savings don’t materialise as forecast. The parties who will actually carry the long term risk – the investor in Green Deal securities, and the future occupier of the house – are by definition the only two parties who will not be in the room when the loan is taken out.

These are the classic conditions for a bubble, which can also be defined as a period of time in which investors provide a sector with more liquidity than discipline. And it is obvious that liquidity and discipline are most likely to be provided in differing amounts when they are provided by different people. Indeed, that is a widely accepted account of what went wrong in the American sub prime mortgage market, where the sales process became so artificially segmented that the people originating mortgages ceased to bear the risk associated with those loans. As a good recent discussion of the financial crisis explains, “the trouble is… that the near risk-free returns on sub-prime mortgages turned out to be little more than clever marketing strategies.” *

And that is exactly what the Green Deal is – a clever marketing strategy. As such it will no doubt be successful in the short run, generating euphoria and new lending in equal measure as the bubble in home energy services starts to build up. This phase may last for a few years, but eventually the poor quality of investments will start to show through, millions of households will find they are in negative equity on their Green Deal plans, and they will start failing – or refusing – to make repayments. The government will discover the fundamental truth that you cannot make an unattractive investment into an attractive one simply by refinancing the cash flows. There will be an outcry, the energy bubble of – let’s say – 2016 will burst, and widespread losses will be incurred.

At that point, we will be ready to move on to the next bubble, whatever it turns out to be.

Sam Arie is a Visiting Fellow at The Smith School of Enterprise & The Environment, Oxford University

* Masters of Nothing, Matthew Hancock & Nadim Zahawi (2011)

 

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